Tighter Monetary Policy Likely to Shape the Markets Through 2018 and Beyond

KING OF PRUSSIA, Pa. — The Federal Reserve (Fed) could soon reach a policy rate that meets or exceeds the neutral rate of interest, leading to increased uncertainty around future Fed moves and potentially to unexpected jolts in the market, according to the recent Investment Insights issued by BNY Mellon’s Lockwood Advisors, Inc. (Lockwood).

The report indicates that the Fed is likely to reach the neutral rate—the long-term interest rate that causes neither overheating (boom) nor lack of demand (recession)—sometime in 2019.

Further, a well-entrenched labor market recovery and a rapidly tightening job market may eventually lead to faster wage gains, reinforcing the Fed’s tightening policy, says the report.

“For U.S. markets, 2019 will likely focus on Fed-watching,” said Matthew Forester, chief investment officer at BNY Mellon’s Lockwood Advisors. “Once the Fed reaches its neutral rate, monetary policy will have a greater impact on the direction of the economy and markets.

“Looking ahead into 2019, we will likely need to adjust to a more normalized rate of corporate earnings growth, as the benefits of the corporate tax cuts are now fully baked into balance sheets. Combined with the implications of monetary policy for the economy, 2019 is likely to be a year where investors will be on high alert on a growing list of factors.”

Highlights from the report include:

As Fed policy becomes less certain, anticipating future rate hikes will become harder. If the Fed holds to the rate policy path it has been communicating, it will likely begin to approach estimates of a neutral rate within three to four rate hikes. As the Fed gets closer to a “neutral” policy stance, it will be critical for the Fed to avoid pitfalls that would shorten an economic cycle that seems poised to be the longest in post-Civil War American history.

Further reduction in the unemployment rate could lead to accelerated wage increases. The labor market has been drawing workers from outside the standard unemployment rolls for most of the current economic cycle. While the composition of job creation during this recovery, combined with the demographic changes (older, more highly compensated and experienced workers leaving the labor force) has kept a lid on wage gains, if the economy continues to propel itself along, it could induce additional wage gains at slightly faster clips—impacting Fed policy as well as bond markets.

Markets will likely continue to look through political trade rhetoric. While trade disputes with China have escalated, trade deals with Mexico and Canada have forced investors to consider that trade spats may have beneficial and mutually agreeable results. Markets are continuing to look through trade rhetoric for a couple of reasons, including the impact of large corporate and personal tax cuts on the broader economy and the fact that the U.S. has great leverage in trade discussions.

Foreign valuations may provide attractive entry points for U.S. investors. Many emerging markets have been hit very hard by trade and currency concerns. These valuation declines came at a time when the spread between U.S. and foreign valuations was already at or near record highs. Foreign valuations have discounted a great deal of bad news and may be nearing attractive longer-term entry points for U.S. investors.

Currency risks are having an impact on portfolios. Asynchronous monetary policy around the globe, combined with strong U.S. corporate and economic results, has led to the strengthening of the dollar, challenging emerging markets and impacting sectors such as commodities where the dollar serves as a base denomination for transactions. Lockwood estimates that currency risk often forms the second largest component of overall risk in a globally balanced portfolio, after economic cycle risk, and warns that many advisors are largely unaware of how impactful currency moves can be on a typical portfolio.

“U.S. equity markets continued to be the star in the third quarter, showing a remarkable resiliency in shrugging off risk,” said Forester. “The markets have weathered higher input costs and tightening monetary policy, thorny trade issues and geopolitical risk—as the underlying economic fundamentals have remained strong. Looking into the fourth quarter, the outcomes of the mid-term elections and any unexpected developments in the Russian interference investigation are two issues that could turn the tide and lead to increased uncertainty in markets.”

For more information on these trends, please visit www.lockwoodadvisors.com to view the full report and relevant disclosures.

This material is intended for informational purposes only and does not constitute investment advice or an offer or solicitation to purchase, hold or sell any securities. The opinions expressed by Lockwood are as of October 2018, and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by Lockwood to be reliable, but are not necessarily all inclusive. This material may contain forward-looking information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.

About BNY Mellon’s Lockwood Advisors, Inc.

Lockwood Advisors, Inc. is a leading provider of managed account solutions. As a program sponsor, Lockwood offers access to some of the industry’s leading investment managers, provides independent research on separate account managers, and develops advisory solutions to help investment professionals meet the diverse needs of their clients.

Lockwood also offers discretionary portfolio management solutions through financial institutions and independent registered investment advisers. Lockwood Advisors, Inc. is an investment adviser registered in the United States under the Investment Advisers Act of 1940, an affiliate of Pershing LLC and a wholly owned subsidiary of The Bank of New York Mellon Corporation (BNY Mellon).

BNY Mellon is a global investments company dedicated to helping its clients manage and service their financial assets throughout the investment lifecycle. Whether providing financial services for institutions, corporations or individual investors, BNY Mellon delivers informed investment management and investment services in 35 countries. As of December 31, 2018, BNY Mellon had $33.1 trillion in assets under custody and/or administration, and $1.7 trillion in assets under management.

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